Who Regulates Whom? An Overview of U.S.
Financial Supervision
Mark Jickling
Specialist in Financial Economics
Edward V. Murphy
Specialist in Financial Economics
December 14, 2009
Congressional Research Service
7-5700
www.crs.gov
R40249
CRS Report for Congress
P
repared for Members and Committees of Congress
Who Regulates Whom? An Overview of U.S. Financial Supervision
Summary
Federal financial regulation in the United States has evolved through a series of piecemeal
responses to developments and crises in financial markets. This report provides an overview of
current U.S. financial regulation: which agencies are responsible for which institutions and
markets, and what kinds of authority they have.
There are two traditional components to U.S. banking regulation: deposit insurance and adequate
capital. Commercial banks accept a quid pro quo that was adopted in response to widespread
bank failures during the 1930s. Through deposit insurance, the federal government provides a
safety net for some banking operations and in return the banks that are exposed to depositor runs
accept federal regulation of their operations, including the amount of risk they may incur. Since
the 1860s, federal banking regulation has sought to prevent excessive risk taking by banks that
might seek to make extra profit by reducing their capital reserves—at the time called “wildcat”
banks. There are five federal bank regulators, each supervising different (and often overlapping)
sets of depository institutions.
Federal securities regulation is based on the principle of disclosure, rather than direct regulation.
Firms that sell securities to the public must register with the Securities and Exchange
Commission (SEC), but the agency has no authority to prevent excessive risk taking. SEC
registration in no way implies that an investment is safe, only that the risks have been fully
disclosed. The SEC also registers several classes of securities market participants and firms, but
relies more on industry self-regulation than do the banking agencies. Derivatives trading is
supervised by the Commodity Futures Trading Commission (CFTC), which oversees trading on
the futures exchanges, which have self-regulatory responsibilities as well. There is also a large
over-the-counter (off-exchange) derivatives market that is largely unregulated.
The Federal Housing Finance Agency (FHFA) oversees a group of government-sponsored
enterprises (GSEs)—public/private hybrid firms that seek both to earn profits and to further the
policy objectives set out in their statutory charters. Two GSEs, Fannie Mae and Freddie Mac,
were placed in conservatorship by the FHFA in September 2008 after losses in mortgage asset
portfolios made them effectively insolvent. A number of financial markets are unregulated,
including some of the largest. No federal agency has jurisdiction over trading in foreign exchange
or U.S. Treasury securities; nonbank lenders fall outside the regulatory umbrella; and hedge
funds, private equity firms, and venture capital investors are largely unregulated (although their
transactions in securities and derivatives markets may be).
The United States has never attempted a wholesale reformation of the entire regulatory system
comparable to the 1986 “Big Bang” in the UK, which reorganized regulatory agencies across
industry lines and sought to implement a consistent philosophy of regulation. In the wake of the
current financial turmoil, however, such a reevaluation is possible, and a number of broad
restructuring proposals have already come forward.
In the 111th Congress, H.R. 4173 presents comprehensive reform of the banking agencies,
derivatives regulation, investor protection, systemic risk, and other concerns. In the Senate, a
committee print by Senator Dodd containing comprehensive reform was issued on November 16,
2009. This report will be updated as conditions warrant.
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Who Regulates Whom? An Overview of U.S. Financial Supervision
Contents
Introduction ................................................................................................................................ 1
Financial Crises, Regulatory Jurisdiction, and Systemic Risk ...................................................... 2
Processes Within the Financial Sector ................................................................................... 3
Honoring Claims of Depositors and Investors........................................................................ 4
Performance of Loans from Banks to the Economy ............................................................... 5
Capital Requirements .................................................................................................................. 7
Non-Bank Capital Requirements ......................................................................................... 10
The SEC’s Net Capital Rule .......................................................................................... 10
CFTC Capital Requirements ......................................................................................... 10
Federal Housing Finance Agency .................................................................................. 11
The Federal Financial Regulators .............................................................................................. 11
Banking Regulators............................................................................................................. 11
Office of the Comptroller of the Currency ..................................................................... 13
Federal Deposit Insurance Corporation.......................................................................... 13
The Federal Reserve...................................................................................................... 14
Office of Thrift Supervision .......................................................................................... 14
National Credit Union Administration ........................................................................... 15
Non-Bank Financial Regulators........................................................................................... 15
Securities and Exchange Commission ........................................................................... 15
Commodity Futures Trading Commission ..................................................................... 17
Federal Housing Finance Agency .................................................................................. 18
Regulatory Umbrella Groups............................................................................................... 19
Federal Financial Institution Examinations Council ....................................................... 19
President’s Working Group on Financial Markets .......................................................... 19
Unregulated Markets and Institutions ........................................................................................ 20
Foreign Exchange Markets.................................................................................................. 20
U.S. Treasury Securities ...................................................................................................... 20
OTC Derivatives ................................................................................................................. 21
Private Securities Markets................................................................................................... 21
Nonbank Lenders................................................................................................................ 22
Hedge Funds ....................................................................................................................... 22
Comprehensive Reform Legislation in the 111th Congress ................................................... 23
Figures
Figure 1. Where Financial Disruptions Arise ............................................................................... 3
Figure A-1. National Bank ........................................................................................................ 24
Figure A-2. National Bank and Subsidiaries .............................................................................. 24
Figure A-3. Bank Holding Company ......................................................................................... 25
Figure A-4. Financial Holding Company ................................................................................... 25
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Who Regulates Whom? An Overview of U.S. Financial Supervision
Tables
Table 1. Systemic Crises and the Creation of Financial Regulators .............................................. 4
Table 2. Federal Financial Regulators and Who They Supervise .................................................. 6
Table 3. The Basel Accords: Risk Weightings for Selected Financial Assets Under the
Standardized Approach ............................................................................................................ 8
Table 4. Capital Standards for Federally Regulated Depository Institutions.................................. 9
Appendixes
Appendix A. Forms of Banking Organizations........................................................................... 24
Appendix B. Bank Ratings: UFIRS and CAMELS .................................................................... 26
Appendix C. Acronyms ............................................................................................................. 28
Appendix D. Glossary of Terms ................................................................................................ 29
Contacts
Author Contact Information ...................................................................................................... 36
Acknowledgments .................................................................................................................... 36
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Who Regulates Whom? An Overview of U.S. Financial Supervision
Introduction
Historically, major changes in financial regulation in the United States have often come in
response to crisis. Thus, one could have predicted that the turmoil beginning in 2007 would lead
to calls for reform. A number of studies and reports have already proposed broad changes to the
division of supervisory authority among the various federal agencies and in the tools and
authorities available to individual regulators. For example, H.R. 4173, the “Wall Street Reform
and Consumer Protection Act of 2009,” would overhaul the financial regulatory structure. A
committee print issued by Senator Dodd on November 16, 2009, the “Restoring American
Financial Stability Act,” would also provide comprehensive reform of the regulatory system.
These legislative efforts follow on the heals of two major proposals by the Treasury Departments
of President Bush and President Obama.1 This report provides a basis for evaluating and
comparing such proposals by setting out the basic structure of federal financial regulation as it
stood at the beginning of the 111th Congress.
Few would argue that regulatory failure was solely to blame for the current crisis, but it is widely
considered to have played a part. In February 2009, Treasury Secretary Timothy Geithner
summed up two key problem areas:
Our financial system operated with large gaps in meaningful oversight, and without
sufficient constraints to limit risk. Even institutions that were overseen by our complicated,
overlapping system of multiple regulators put themselves in a position of extreme
vulnerability. These failures helped lay the foundation for the worst economic crisis in
generations.2
In this analysis, regulation failed to maintain financial stability at the systemic level because there
were gaps in regulatory jurisdiction and because even overlapping jurisdictions—where
institutions were subject to more than one regulator—could not ensure the soundness of regulated
financial firms. In addition, limits on risk-taking were insufficient. Regulators have a number of
risk-reduction tools at their disposal, but the chief one is capital regulation—standards that
require firms to maintain capital cushions to protect themselves against unexpected losses.
To create a context for what follows, this report begins with basic analysis of systemic risk and
capital regulation. The first section briefly discusses regulatory jurisdiction and systemic risk, and
includes a chart listing the major regulators and the types of institutions they supervise. The chart
also indicates certain emergency authorities available to the regulators, including those that relate
to systemic financial disturbances. The second section focuses on capital requirements and how
standards are set by bank, securities, and futures regulators.
The next section provides a brief overview of each of the federal financial regulatory agencies.
Because the current crisis is likely to provoke a serious reconsideration of the levels of capital
1 See, e.g., U.S. Treasury, Blueprint for a Modernized Financial Regulatory Structure, March 2008,
http://www.treas.gov/press/releases/reports/Blueprint.pdf; Group of Thirty, Financial Reform: A Framework for
Financial Stability, January 2009, http://www.group30.org/pubs/recommendations.pdf; Congressional Oversight Panel,
Special Report on Regulatory Reform, January 2009, http://cop.senate.gov/documents/cop-012909-report-
regulatoryreform.pdf; and Government Accountability Office, Financial Regulation: A Framework for Crafting and
Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System, GAO-09-310T, January 14, 2009.
2 Remarks by Treasury Secretary Timothy Geithner Introducing the Financial Stability Plan, February 10, 2009,
http://www.ustreas.gov/press/releases/tg18.htm.
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that financial firms should be required to maintain as a cushion against insolvency, the capital
standards that each agency applies to various classes of financial firms are also set out.
Finally, the report discusses of several major areas of financial markets that are not subject to any
federal regulation.
Financial Crises, Regulatory Jurisdiction, and
Systemic Risk
The United States has experienced several financial panics and economic disruptions in its
history. Reactions to financial disruptions have resulted in a complex regulatory framework, in
which some agencies have overlapping jurisdictions, and where there may be some regulatory
gaps. With each new crisis, including the current one, there are calls to address perceived gaps
and weaknesses in the regulatory system. Financial disruptions can originate from at least three
sources:
• failures within the financial system itself, such as a breakdown in the ability of
banks and other financial intermediaries to process their obligations to one
another in a timely and efficient manner;
• demands on the financial system from other sectors of the economy, such as
unexpected pressure on banks to honor their obligations to depositors and
investors more quickly than they can accumulate liquid assets; and
• weakness in real economic sectors, such as an unexpected drop in the capacity of
firms and consumers to repay bank loans.
These three types of problems are illustrated in the Figure 1 and discussed below.
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Figure 1. Where Financial Disruptions Arise
Source: CRS.
Processes Within the Financial Sector
Financial disruptions can manifest themselves within the financial sector itself (represented in the
Figure 1 by the numeral 1). For example, banks may have trouble processing checks and other
third-party claims, or loans to other banks. Because the willingness and ability of market
participants to extend loans and make trades often depends on trust that others will honor their
obligations to them in a timely manner, disruptions in interbank lending markets, clearinghouses,
and trading exchanges can disrupt financial flows to the wider economy.3 The Panic of 1857 may
represent an instance in which interbank markets failed and contributed to a wider recession—
subsequent reforms sought to redress problems within the financial sector itself. Prior to the Civil
War, the debts of state-chartered banks circulated as currency. A clearinghouse system was
required to process these state bank notes, which often traded at a discount vis-a-vis each other,
similar to the way that international currencies today have exchange rates. The value of a state
bank note often depended on the perceived safety and soundness of the banks that issued the note.
Private inter-bank clearinghouse systems, such as New England’s Suffolk Bank, coordinated the
processing of bank claims. The Panic of 1857 was a financial crisis in which the value of state
bank notes became uncertain and the wider economy suffered a recession. The Suffolk Bank
failed in 1858. Partially in response to this crisis, the United States established a single national
3 Examples of potential disruptions that markets appear to have handled with relative resilience include the stock
market crash of 1987, during which the stock ticker “ran late,” and more recent concern that the trading technology for
credit default swaps might not be able to process the volume of obligations if a large institution such as Fannie Mae or
Freddie Mac suffered a credit event. Currently, the Federal Reserve oversees a domestic interbank clearing system for
banks while the CFTC and the SEC oversee trading exchanges for commodities and securities respectively.
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currency, coordinated through a system of federally chartered banks. The safety and soundness of
these banks is regulated by the Office of the Comptroller of the Currency (OCC), established in
1863, as part of banking reforms designed to ease funding of the Civil War.
Honoring Claims of Depositors and Investors
Financial disruptions can result from problems between banks and their sources of funding,
whether investors or depositors (indicated by the numeral 2 in the Figure 1). Banks and other
financial intermediaries often have a timing mismatch: the value of their assets may only be
recoverable over a long period of time, but their liabilities may be subject to immediate
repayment. Banks plan for this duration mismatch using a variety of risk-management techniques,
but at the end of the day, there are limits to their ability to accommodate changes in
investor/depositor behavior. If investors or depositors demand repayment too quickly, a bank may
be forced to sell its less liquid assets at a steep discount to meet immediate obligations. The
resulting losses, or the fear of such losses, can damage the financial system and cut off credit to
the wider economy.
The Panic of 1907 may represent an instance in which banks were unprepared for changes in the
behavior of investors and depositors. In 1907, the seasonal increase in demand for currency
coincided with disruptions in the New York money market caused by a commodities speculator.
F.A. Heinze had used funds from the Mercantile National Bank, which was subject to OCC
supervision, in a failed attempt to corner the copper market. Fearing bank insolvency, depositors
began a series of runs on institutions believed to be associated with Heinze, including the New
York Knickerbocker Bank. During the ensuing liquidity crisis, the swamped OCC staff’s response
time for currency deliveries slowed down even as demand for money increased. National banks
turned to a variety of substitutes for national currency, including the financial resources of
investor J.P. Morgan. Partially as a response to this crisis, the United States established a system
of federally regulated bank reserves. The Federal Reserve was created in 1914.
The Great Depression may represent another episode in which banks were unprepared for
changes in depositor behavior. Rising unemployment both increased the need for households to
withdraw their savings deposits and reduced the flow of funds into banks through loan
repayment. Fear that banks would not be able to honor their commitments to depositors caused a
series of bank runs in 1931 and 1933, which forced banks to sell assets at steep discounts. To
reduce the likelihood of future bank runs, Congress established a federal insurance program for
bank deposits: the Federal Deposit Insurance Corporation (FDIC) was created in 1933.
Table 1. Systemic Crises and the Creation of Financial Regulators
Year
Systemic Event
Perceived Problem
Solution
New Regulator
Created
Panic of 1857
Failure of Private
Create Single National
Office of the
1863
Clearinghouses that
Currency Through System
Comptroller of the
Processed State Bank
of Federally Chartered and
Currency (OCC)
Notes (circulated as
Regulated Banks
currency)
Panic of 1907
Series of Runs on Banks
Create Lender of Last
Federal Reserve
1913
and Financial Trusts
Resort with Power to
with Inadequate
Regulate a National System
Reserves
of Bank Reserves
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Year
Systemic Event
Perceived Problem
Solution
New Regulator
Created
Great Depression Series of Runs on Banks
Create Limited Deposit
Federal Deposit
1933
by Smal Depositors
Insurance to Maintain
Insurance
who Feared Full Value
Depositor Confidence and
Corporation (FDIC)
of Deposits Would Not
Prevent Bank Runs
be Honored
Sharp Decline in Stock
Restore Confidence in
Securities and
1934
Prices along with
Securities Markets by
Exchange Commission
Widespread Belief that
Standardizing Disclosures
(SEC)
Some Investors had an
and Requiring Regular
Information Advantage
Reporting
Reduced Confidence in
Securities Markets
Source: CRS.
Performance of Loans from Banks to the Economy
Financial disruptions can also result from worse-than-expected performance of loans from banks
to households, businesses, and governments, indicated by the numeral 3 in the figure above.
Banks and other financial intermediaries do not expect all loans to be repaid on time and in full;
rather, there is always some allowance for loan losses. When loan losses rise above expectations,
however, banks become less capitalized. To avoid an undercapitalized system, the OCC and other
regulators with safety and soundness authority require subject institutions to prepare for some
loan losses. In addition, they examine subject institutions’ loan portfolios to assess the overall
prudence of lending behavior and attempt to prevent overly risky lending.
During the 2001-2005 housing boom, large volumes of mortgage lending were conducted through
non-bank institutions, which were not subject to the prudential lending standards of the bank
regulators. Many large banks bought mortgage-backed securities based on such loans—or
assumed the equivalent risk exposure through off-balance sheet financing arrangements or
derivatives contracts—and have since suffered unexpected losses and become undercapitalized.
Some believe that the current crisis is evidence of a regulatory gap, and have called for the
establishment of a new systemic risk regulator with authority to oversee all financial institutions
and firms that could trigger a systemic disruption.
Thus, new proposals to create a regulator exclusively concerned with systemic risk repeat the
pattern that has characterized the development of U.S. financial regulation. The term “systemic
risk” does not have a single, agreed-upon definition. Some define systemic risk as the risk an
institution faces that it cannot diversify against. In other circumstances, systemic risk is defined as
the risk that the linkages between institutions may affect the financial system as a whole, through
a dynamic sometimes referred to as contagion. These definitions are compatible in some cases;
for example, the linkages between financial institutions could prevent any single lender from
effectively protecting itself from problems that emerge in the system as a whole.
The two definitions do not always apply to the same circumstances. Particular institutions in
some sectors might face risks that are not diversifiable and that arise from sources other than the
financial system. Similarly, linkages between institutions can create aggregate risks that
individual institutions could hedge against if they chose to do so, but there is no assurance that the
institutions would. In fact, another way to think about systemic risk is that it arises because all
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market participants have incentives to limit their own risk-taking to prevent loss of the own
capital, but no participant will willingly limit its risk-taking—the source of its profitability—to
reduce the possibility of a systemic disruption.
Asset bubbles represent one form of systemic risk. In good times, loans are less likely to default;
therefore, it might make sense for any individual bank to increase its leverage and reduce its
capital reserves. However, overly easy lending and reduced capital reserves in good times can
lead to a bubble in the price of assets financed with loans, such as farms or houses (even tulip
bulbs). When the bubble eventually deflates, simultaneous deterioration of banks’ balance sheets
can result.
Over the years, the financial regulatory system has been modified to address various sources of
financial instability and evolving concepts of systemic risk. Not all federal financial regulators
have authority to address systemic risk, and no single regulator has jurisdiction over all the
financial institutions and markets that may become sources of systemic risk.
Table 2 below sets out the current federal financial regulatory structure: the agencies and the
financial institutions they regulate. Supplemental material—charts that illustrate the differences
between banks, bank holding companies, and financial holding companies—appears in Appendix
A.
Table 2. Federal Financial Regulators and Who They Supervise
Emergency/Systemic
Other Notable
Regulatory Agency
Institutions Regulated
Risk Powers
Authority
Federal Reserve
Bank holding companies,a
Lender of last resort to
The Fed issues consumer
financial holding
member banks (through
protection regulations
companies, state banks
discount window lending).
under various federal laws,
that are members of the
In “unusual and exigent
including the Truth-in-
Federal Reserve System,
circumstances” the Fed
Lending Act
U.S. branches of foreign
may lend to “any
banks, foreign branches of
individual, partnership, or
U.S. banks
corporation ... ”
Office of the Comptrol er
National banks, U.S.
of the Currency (OCC)
federal branches of foreign
banks
Federal Deposit Insurance
Federally-insured
After making a
Corporation (FDIC)
depository institutions,
determination of systemic
including state banks that
risk, the FDIC may invoke
are not members of the
broad authority to use the
Federal Reserve System
deposit insurance funds to
provide an array of
assistance to depository
institutions
Office of Thrift
Federally chartered and
Supervision (OTS)
insured thrift institutions,
savings and loan holding
companies
National Credit Union
Federally-chartered or
Serves as a liquidity lender
Operates a deposit
Administration (NCUA)
insured credit unions
to credit unions
insurance fund for credit
experiencing liquidity
unions, the National
shortfal s through the
Credit Union Share
Central Liquidity Facility
Insurance Fund (NCUSIF)
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Emergency/Systemic
Other Notable
Regulatory Agency
Institutions Regulated
Risk Powers
Authority
Securities and Exchange
Securities exchanges,
May unilaterally close
Authorized to set financial
Commission (SEC)
brokers, and dealers;
markets or suspend
accounting standards
mutual funds; investment
trading strategies for
which al publicly traded
advisers. Registers
limited periods
firms must use
corporate securities sold
to the public
Commodity Futures
Futures exchanges,
May suspend trading,
Trading Commission
brokers, pool operators,
order liquidation of
(CFTC)
advisers
positions, or raise margins
in emergencies.
Federal Housing Finance
Fannie Mae, Freddie Mac,
Acting as conservator
Agency (FHFA)
and the Federal Home
(since Sept. 2008) for
Loan Banks
Fannie and Freddie
Source: CRS.
Notes: For more detail on banking regulation, see the chart “Banking Institutions and Their Regulators,”
http://www.newyorkfed.org/publications.
a. See Appendix A.
Capital Requirements
As a general accounting concept, capital means the equity of a business—the amount by which its
assets exceed its liabilities.4 The more capital a firm has, the greater its capacity to absorb losses
and remain solvent. Financial regulators require the institutions they supervise to maintain
specified minimum levels of capital—defined in various ways—in order to reduce the number of
failing firms and to minimize losses to investors, customers, and taxpayers when failures do
occur. Capital requirements represent a cost to businesses because they restrict the amount of
funds that may be loaned or invested in the markets. Thus, there is a perpetual tension: firms
structure their portfolios to reduce the amount of capital they must hold, while regulators
continually modify capital standards to prevent excessive risk-taking.
In U.S. banking regulation, capital standards are based on the Basel Accords, an international
framework developed under the auspices of the Bank for International Settlements.5 The guiding
principle of the Basel standards is that capital requirements should be risk-based. The riskier an
asset, the more capital a bank should hold against possible losses. The Basel Accords provide two
broad methodologies for calculating risk-based capital: (1) a standardized approach to credit risk
determinations, based on external risk assessments (such as bond ratings), and (2) an alternative
approach that relies on banks’ internal risk models and rating systems. Adoption of the latter
method—set out in the 2004 Basel II framework—in the United States has been slow, and thus far
is limited to a few large banks.6
4 Regulatory uses of “capital” include more specific definitions and classifications.
5 See CRS Report RL33278, The Basel Accords: The Implementation of II and the Modification of I, by Walter W.
Eubanks.
6 See CRS Report RL34485, Basel II in the United States: Progress Toward a Workable Framework, by Walter W.
Eubanks.
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Table 3 shows how the standardized approach works in assessing the amount of capital to be held
against credit risk in various types of financial instruments. The Basel Accords call for a basic
capital requirement of 8% of the value of an asset; the risk-weighting then determines what
percentage of that 8% baseline will apply to a given asset. For example, if the risk-weighting is
0%, no capital must be held (i.e., 8% X 0% = 0). A risk weighting of 100% means that the full 8%
requirement applies. Assets weighted above 100% require that a multiple of the 8% capital
requirement be held.
Table 3. The Basel Accords: Risk Weightings for Selected Financial Assets Under the
Standardized Approach
(percentages of the 8% baseline capital requirement)
BBB+ to
Asset
AAA to AA-
A+ to A-
BBB-
BB+ to B-
Below B-
Unrated
Sovereign
Debt
0% 20% 50% 100% 150% 100%
Bank
Debt 20% 50% 50% 100% 150% 100%
Corporate Debt
20%
50%
100%
NA
150% (below
100%
BB-)
Assets not Assigned Ratings by Standard & Poor’s or other Credit Rating Agencies
Residential Mortgages
35%
Commercial Real Estate
100%
Past Due Loans
100%-150% (depending on specific provisions made to cover loan losses)
Securitization Tranches rated between BB+ and BB- 350%
Source: Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital
Standards, BIS, November 2005, pp. 15-22.
Federal banking regulators use the Basel Accords as the basis for their capital requirements.
Table 4 sets out the specific standards imposed by each.
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Table 4. Capital Standards for Federally Regulated Depository Institutions
Agency Capital
Standard
Source
OCC
Minimum risk-based capital ratio of 8%. (The ratio measures bank capital against assets, with asset values risk-weighted, or adjusted
12 CFR § 3.6 (“Minimum capital
on a scale of riskiness.)
ratios”)
In addition, banks must maintain Tier 1 capitala in an amount equal to at least 3.0% of adjusted total assets. (A simple definition of
Tier 1 capital is stockholders’ equity, or the net worth of the institution. ) The 3% total assets leverage ratio applies to the most
highly rated banks, which are expected to have well-diversified risks, including no undue interest rate risk exposure; excellent
control systems; good earnings; high asset quality; high liquidity; and well managed on-and off-balance sheet activities; and in general
be considered strong banking organizations, with a rating of 1 under CAMELSb rating system of banks. For other banks, the
minimum Tier 1 leverage ratio is 4%.
FDIC
The FDIC requires institutions to maintain the same minimum leverage capital requirements (ratio of Tier 1 capital to assets) as the
12 CFR § 325.3, (“Minimum
OCC, that is, 3% for the most highly-rated institutions and 4% for others.
leverage capital requirement”)
Federal Reserve
State banks that are members of the Federal Reserve System must meet an 8% risk-weighted capital standard, of which at least 4%
12 CFR § 208.4, Regulation H
must be Tier 1 capital (3% for strong banking institutions rated “1” under the CAMELS rating system of banks).
(“Membership of State Banking
Institutions in the Federal
In addition, the Fed establishes levels of reserves that depository institutions are required to maintain for the purpose of facilitating
Reserve System”) and 12 CFR §
the implementation of monetary policy by the Federal Reserve System. Reserves consist of vault cash (currency) or deposits at the
204.9 (Reserve requirements)
nearest regional Federal Reserve branch, held against the bank’s deposit liabilities, primarily checking, saving, and time deposits
(CDs). The size of these reserves places a ceiling on the amount of deposits that financial institutions can have outstanding, and ties
deposit liabilities to the amount of assets (loans) these institutions can acquire.
OTS
Risk-based capital must be at least 8% of risk-weighted assets. Federal statute requires that OTS capital regulations be no less
12 CFR §567
stringent than the OCC’s. Tangible capital must exceed 1.5% of adjusted total assets. The leverage ratio (Tier 1 capital to assets)
must be 4% of adjusted total assets (3% for thrifts with a composite CAMELS rating of 1).
NCUA
Credit unions must maintain a risk-based net worth of 7%, as a minimum to be considered well-capitalized.
NCUA Regulations (Section 702,
Subpart A)
Source: CRS.
a. Tier 1 capital or core capital means the sum of common stockholders’ equity, noncumulative perpetual preferred stock, and minority interests in consolidated
subsidiaries, minus all intangible assets, minus identified losses, minus investments in certain financial subsidiaries, and minus the amount of the total adjusted carrying
value of nonfinancial equity investments that is subject to a deduction from Tier 1 capital.
b. See Appendix B.
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Non-Bank Capital Requirements
The SEC’s Net Capital Rule
The SEC’s net capital rule, set out in17 CFR 240.15c3-1, imposes an “Aggregate Indebtedness
Standard.” No broker/dealer shall permit its aggregate indebtedness to all other persons to exceed
1500% of its net capital (or 800% of its net capital for 12 months after commencing business as a
broker or dealer). The 1500% (or 15-to-1) ratio of debt to liquid capital, is arithmetically
equivalent to a 6⅔% capital requirement.
To calculate liquid capital, SEC rules require that securities and other assets be given a “haircut”
from their current market values (or face value, in the case of bonds), to cover the risk that the
asset’s value might decline before it could be sold. The haircut concept is essentially the same as
the standardized risk weights in the Basel Accords. The riskier the asset, the greater the haircut.
For example, U.S. Treasury securities might have a haircut of zero to 1%; municipal securities,
7%; corporate bonds, 15%; common stock, 20%; and certain assets, such as unsecured
receivables or securities for which no ready market exists, receive a haircut of 100%. As
discussed below, the intent of the net capital rule is not the same as that of banking capital
requirements, because the SEC is not a safety and soundness regulator. The net capital rule is
meant to ensure that brokerages cease operations while they still have assets to meet their
customers’ claims.
CFTC Capital Requirements
Futures commission merchants (or FCMs, the futures equivalent of a securities broker/dealer) are
subject to adjusted net capital requirements. Authority to enforce the capital rules is delegated by
the CFTC to the National Futures Association (NFA), a self-regulatory organization created by
Congress.
Each NFA Member that is required to be registered with the CFTC as a Futures Commission
Merchant (Member FCM) must maintain “Adjusted Net Capital” (as defined in CFTC Regulation
1.17) equal to or in excess of the greatest of:
(i) $500,000;
(ii) For Member FCMs with less than $2,000,000 in Adjusted Net Capital, $6,000 for
each remote location operated;
(iii) For Member FCMs with less than $2,000,000 in Adjusted Net Capital, $3,000 for
each associated person;
(iv) For securities brokers and dealers, the amount of net capital specified by SEC
regulations;
(v) 8% of domestic and foreign domiciled customer and 4% of non-customer (excluding
proprietary) risk maintenance margin/performance bond requirements for all domestic
and foreign futures and options on futures contracts excluding the risk margin associated
with naked long option positions;
(vi) For Member FCMs with an affiliate that engages in foreign exchange (FX)
transactions and that is authorized to engage in those transactions solely by virtue of its
affiliation with a registered FCM, $7,500,000; or
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(vii) For Member FCMs that are counterparties to FX options, $5,000,000, except that
FX Dealer Members must meet the higher requirement in Financial Requirements
Section 11.7
Federal Housing Finance Agency
FHFA is authorized to set capital classification standards for the Federal Home Loan Banks,
Fannie Mae, and Freddie Mac that reflect the differences in operations between the banks and the
latter two gocerbment-sponsored enterprises.8 The law defines several capital classifications, and
prescribes regulatory actions to be taken as a GSE’s condition worsens.
FHFA may downgrade the capital classification of a regulated entity (1) whose conduct could
rapidly deplete core or total capital, or (in the case of Fannie or Freddie) whose mortgage assets
have declined significantly in value, (2) which is determined (after notice and opportunity for a
hearing) to be in an unsafe or unsound condition, or (3) which is engaging in an unsafe or
unsound practice.
No growth in total assets is permitted for an undercapitalized GSE, unless (1) FHFA has accepted
the GSE’s capital restoration plan, (2) an increase in assets is consistent with the plan, and (3) the
ratio of both total capital to assets and tangible equity to assets is increasing. An undercapitalized
entity is subject to heightened scrutiny and supervision.
If a regulated entity is significantly undercapitalized, FHFA must take one or more of the
following actions: new election of Directors, dismissal of Directors and/or executives, and hiring
of qualified executive officers, or other actions. Without prior written approval, executives of a
significantly undercapitalized regulated entity may not receive bonuses or pay raises. In addition,
FHFA may appoint a receiver or conservator for several specified causes related to financial
difficulty and/or violations of law or regulation.
When a GSE becomes critically undercapitalized, mandatory receivership or conservatorship
provisions apply. For example, FHFA must appoint itself as the receiver if a regulated entity’s
assets are (and have been for 60 days) less than its obligations to its creditors, or if the regulated
entity has (for 60 days) not been generally paying its debts as they come due. The FHFA
appointed itself conservator for both Fannie and Freddie in September 2008, before either GSE
had failed to make timely payments on debt obligations.
The Federal Financial Regulators
Banking Regulators
Banking regulation in United States has evolved over time into a system of multiple regulators
with overlapping jurisdictions. There is a dual banking system, in which each depository
institution is subject to regulation by its chartering authority: state or federal. In addition, because
7 National Futures Association, NFA Manual/Rules, Section 7001. http://www.nfa.futures.org/nfaManual/
manualFinancial.asp#fins1.
8 See Sections 1142 and 1143 of the Housing and Economic Recovery Act of 2008, P.L. 110-289.
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virtually all depository institutions are federally insured, they are subject to at least one federal
primary regulator (i.e., the federal authority responsible for examining the institution for safety
and soundness and for ensuring its compliance with federal banking laws). The primary federal
regulator of national banks is their chartering authority, the Office of the Comptroller of the
Currency (OCC). The primary federal regulator of state-chartered banks that are members of the
Federal Reserve System is the Board of Governors of the Federal Reserve System. State-
chartered banks that are not members of the Federal Reserve System have the FDIC as their
primary federal regulator. Thrifts (both state- or federally chartered) have the Office of Thrift
Supervision as their primary federal regulator. All of these, because their deposits are covered by
FDIC deposit insurance, are also subject to FDIC’s regulatory authority. Credit unions–federally
chartered or federally insured–are regulated by the National Credit Union Administration. Federal
consumer protection laws, many of which are implemented under rules issued by the Board of
Governors of the Federal Reserve System, are enforced upon depository institutions by their
primary federal regulator.
In general, lenders are expected to be prudent when extending loans. Each loan creates risk for
the lender. The overall portfolio of loans extended or held by a lender, in relation to other assets
and liabilities, affects that institution’s stability. The relationship of lenders to each other, and to
wider financial markets, affects the financial system’s stability. The nature of these risks can vary
between industry sectors, including commercial loans, farm loans, and consumer loans. Safety
and soundness regulation encompasses the characteristics of (1) each loan, (2) the balance sheet
of each institution, and (3) the risks in the system as a whole.
Each loan has a variety of risk characteristics of concern to lenders and their regulators. Some of
these risk characteristics can be estimated at the time the loan is issued. Credit risk, for example,
is the risk that the borrower will fail to repay the principal of the loan as promised. Rising interest
rates create another risk because the shorter-term interest rates that the lender often pays for its
funds rise (e.g., deposit or CD rates) while the longer-term interest rates that the lender will
receive from fixed-rate borrowers remain unchanged. Falling interest rates are not riskless either:
fixed-rate borrowers may choose to repay loans early, reducing the lender’s expected future cash
flow. Federal financial regulators take into account expected default rates, prepayment rates,
interest-rate exposure, and other risks when examining the loans issued by covered lenders.
Each lender’s balance sheet can reduce or enhance the risks of the individual loans that make it
up. A lender with many loans exposed to prepayment risk when interest rates fall, for example,
could compensate by acquiring some assets that rise in value when interest rates fall. One
example of a compensating asset would be an interest-rate derivative contract. Lenders are
required to keep capital in reserve against the possibility of a drop in value of loan portfolios or
other risky assets. Federal financial regulators take into account compensating assets, risk-based
capital requirements, and other prudential standards when examining the balance sheets of
covered lenders.
When regulators determine that a bank is taking excessive risks, or engaging in unsafe and
unsound practices, they have a number of powerful tools at their disposal to reduce risk to the
institution (and ultimately to the federal deposit insurance fund). They can require banks to
reduce specified lending or financing practices, dispose of certain assets, and order banks to take
steps to restore sound balance sheets. Banks have no alternative but to comply, since regulators
have life-or-death options, such as withdrawing deposit insurance or seizing the bank outright.
The five federal banking agencies are briefly discussed below.
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Office of the Comptroller of the Currency
The Office of the Comptroller of the Currency (OCC) was created in 1863 as part of the
Department of Treasury to supervise federally chartered banks (“national” banks) and to replace
the circulation of state bank notes with a single national currency (Chapter 106, 13 STAT. 99).
The OCC regulates a wide variety of financial functions, but only for federally chartered banks.
The head of the OCC, the Comptroller, is also a member of the board of the FDIC and a director
of the Neighborhood Reinvestment Corporation. The OCC has examination powers to enforce its
responsibilities for the safety and soundness of nationally chartered banks. The OCC has strong
enforcement powers, including the ability to issue cease and desist orders and revoke federal bank
charters.
In addition to institution-level examinations, the OCC oversees systemic risk among nationally
chartered banks. The OCC’s use of the term systemic risk is more consistent with the linkages
definition than the undiversifiable risk definition. One example of OCC systemic concerns is the
regular survey of credit underwriting practices. This survey compares underwriting standards
over time and assesses whether OCC examiners believe the credit risk of nationally chartered
bank portfolios is rising or falling. In addition, the OCC publishes regular reports on the
derivatives activities of U.S. commercial banks.
Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation (FDIC) was created in 1933 to provide assurance to
small depositors that they would not lose their savings if their bank failed (P.L. 74-305, 49 Stat.
684). The FDIC is an independent agency that insures deposits, examines and supervises financial
institutions, and manages receiverships, assuming and disposing of the assets of failed banks. The
FDIC manages the deposit insurance fund, which consists of risk-based assessments levied on
depository institutions. The fund is used for various purposes, primarily for resolving failed or
failing institutions. The FDIC has broad jurisdiction because nearly all banks and thrifts, whether
federally or state-chartered, carry FDIC insurance.
Deposit insurance reform was enacted in 2006 (P.L. 109-173, 119 STAT. 3601), including raising
the coverage limit for retirement accounts to $250,000 and indexing both its limit and the general
deposit insurance coverage ceiling to inflation. The reform act made changes to the risk-based
assessment system to determine the payments of individual institutions. Within a range set by the
reform act, the FDIC uses notice and comment rulemaking to set the designated reserve ratio
(DRR) that supports the Deposit Insurance Fund (DIF). The FDIC uses its power to examine
individual institutions and to issue regulations for all insured depository institutions to monitor
and enforce safety and soundness.
In 2008, as the financial crisis worsened, Congress enacted a temporary increase in the deposit
insurance ceiling from $100,000 to $250,000 for most accounts.9 Using emergency authority it
received under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA,
P.L. 102-242),10 the FDIC made a determination of systemic risk in October 2008 and announced
that it would temporarily guarantee (1) newly issued senior unsecured debt of banks, thrifts, and
9 Section 135 of the Emergency Economic Stabilization Act of 2008 (EESA, P.L. 110-343).
10 FDICIA created a new section 13(c)(4) of the Federal Deposit Insurance Act,12 USC § 1823(c)(4)(G).
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certain holding companies, and (2) non-interest bearing deposit transaction accounts (e.g.,
business checking accounts), regardless of dollar amount.11
The Federal Reserve
The Board of Governors of the Federal Reserve System was established in 1913 to provide
stability in the banking sector through the regulation of bank reserves (P.L. 63-43, 38 STAT. 251).
The System consists of the Board of Governors in Washington and 12 regional reserve banks. In
addition to its authority to conduct national monetary policy, the Federal Reserve has safety and
soundness examination authority for a variety of lending institutions including bank holding
companies; U.S. branches of foreign banks; and state-chartered banks that are members of the
federal reserve system. Under the Gramm-Leach-Bliley Act (GLBA, P.L. 106-102), the Fed
serves as the umbrella regulator for financial holding companies, which are defined as
conglomerates that are permitted to engage in a broad array of financially related activities.
In addition to institution-level examinations of covered lenders, the Federal Reserve oversees
systemic risk. This role has come about not entirely through deliberate policy choices, but partly
by default, as a result of the Fed’s position as lender of last resort and its consequent ability to
inject capital or liquidity into troubled institutions. The Federal Reserve’s standard response to a
financial crisis has been to announce that it stood ready to provide liquidity to the system. This
announcement worked well until 2007: a range of crises—the Penn Central bankruptcy, the stock
market crash of 1987, the junk bond collapse, sovereign debt crises, the Asian crises of 1997-
1998, the dot.com crash, and the 9/11 attacks—were quickly brought under control without
systemic consequences. In 2007, however, the Fed’s liquidity provision failed to restore stability.
As a result, the Fed’s role as the primary systemic risk regulator will be closely scrutinized.
Office of Thrift Supervision
The Office of Thrift Supervision (OTS), created in 1989 during the savings and loan crisis (P.L.
101-73, 103 STAT. 183), is the successor institution to the Federal Savings and Loan Insurance
Corporation (FSLIC), created in 1934 and administered by the old Federal Home Loan Bank
Board. The OTS has the responsibility of monitoring the safety and soundness of federal savings
associations and their holding companies. The OTS also supervises federally insured state savings
associations. The OTS is part of the Treasury Department but is primarily funded by assessments
on covered institutions. The primary business model of most thrifts is accepting deposits and
offering home loans, but thrifts offer many other financial services.
There are three main advantages for firms to choose a federal thrift charter. First, a federal thrift
charter shields the institution from some state regulations, because federal banking law can
preempt state law.12 Second, a federal thrift charter permits the institution to open branches
nationwide under a single regulator, while state-chartered thrifts must comply with multiple state
regulators. Third, a federal thrift charter and its holding company are regulated by the same
regulator, but a federal bank charter may split regulation of the institution (OCC) from regulation
11 “FDIC Announces Plan to Free Up Bank Liquidity,” press release, October 14, 2008, http://www.fdic.gov/news/
news/press/2008/pr08100.html.
12 The scope of federal preemption has been the subject of recent court decisions. See CRS Report RS22485, Watters v.
Wachovia Bank, N.A., by M. Maureen Murphy.
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of its holding company (FRB). Thus, a number of diversified financial institutions that are not
primarily savings and loans have come under the supervision of OTS as “thrift holding
companies,” including Lehman Brothers, AIG, and Morgan Stanley.
OTS was created in response to the savings and loan crisis of the late 1980s. That crisis was
characterized by an increase in the number of bad loans coincident with inflation, rising costs of
deposits, and significantly declining collateral values, primarily in commercial real estate. The
magnitude of the losses threatened to overwhelm the deposit insurance funds in the FSLIC. In
1989 Congress enacted the Financial Institutions Reform, Recovery, and Enforcement Act of
1989 (FIRREA, P.L. 101-73), which reorganized thrift regulation and created OTS. FIRREA also
created the Resolution Trust Corporation (RTC), charged with sorting out which thrifts could be
successfully reorganized or merged with others and which were beyond help. The RTC paid
deposit insurance claims and liquidated the assets of failed thrifts.
National Credit Union Administration
The National Credit Union Administration (NCUA), originally part of the Farm Credit
Administration, became an independent agency in 1970 (P.L. 91-206, 84 STAT. 49). The NCUA
regulates all federal credit unions and those state credit unions that elect to be federally insured. It
administers a Central Liquidity Facility, which is the credit union lender of last resort, and the
National Credit Union Share Insurance Fund, which insures credit union deposits. Credit unions
are member-owned financial cooperatives, and must be not-for-profit institutions. As such, they
receive preferential tax treatment compared to mid-sized banks.
Non-Bank Financial Regulators
Securities and Exchange Commission
The Securities and Exchange Commission (SEC) was created as an independent agency in 1934
to enforce newly-written federal securities laws (P.L. 73-291, 48 Stat. 881). The SEC is not
primarily concerned with ensuring the safety and soundness of the firms it regulates, but rather
with maintaining fair and orderly markets and protecting investors from fraud. This distinction
largely arises from the absence of government guarantees for securities investors comparable to
deposit insurance. The SEC does not have the authority to limit risks taken by non-bank financial
institutions, nor the ability to prop up a failing firm. Two types of firms come under the SEC’s
jurisdiction: (1) all corporations that sell securities to the public, and (2) securities broker/dealers
and other securities markets intermediaries.
Firms that sell securities—stocks and bonds—to the public are required to register with the SEC.
Registration entails the publication of detailed information about the firm, its management, the
intended uses for the funds raised through the sale of securities, and the risks to investors. The
initial registration disclosures must be kept current through the filing of periodic financial
statements: annual and quarterly reports (as well as special reports when there is a material
change in the firm’s financial condition or prospects).
Beyond these disclosure requirements, and certain other rules that apply to corporate governance,
the SEC does not have any direct regulatory control over publicly traded firms. Bank regulators
are expected to identify unsafe and unsound banking practices in the institutions they supervise,
and have power to intervene and prevent banks from taking excessive risks. The SEC has no
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comparable authority; the securities laws simply require that risks be disclosed to investors.
Registration with the SEC, in other words, is in no sense a guarantee that a security is a good or
safe investment.
To enable investors to make informed investment choices, the SEC has statutory authority over
financial accounting standards. All publicly traded firms are required to use generally accepted
accounting principles (GAAP), which are formulated by the Financial Accounting Standards
Board (FASB), the American Institute of Certified Public Accountants (AICPA), and the SEC
itself.
Besides publicly traded corporations, a number of securities market participants are also required
to register with the SEC (or with one of the industry self-regulatory organizations that the SEC
oversees). These include stock exchanges, securities brokerages (and numerous classes of their
personnel), mutual funds, auditors, investment advisers, and others. To maintain their registered
status, all these entities must comply with rules meant to protect public investors, prevent fraud,
and promote fair and orderly markets. The area of SEC supervision most analogous to banking
regulation is broker/dealer regulation. Several provisions of law and regulation protect brokerage
customers from losses arising from brokerage firm failure. The Securities Investor Protection
Corporation (SIPC), created by Congress in 1970, operates an insurance scheme funded by
assessments on broker/dealers (and with a backup line of credit with the U.S. Treasury). SIPC
guarantees customer accounts up to $500,000 for losses arising from brokerage failure or fraud
(but not market losses). Unlike the FDIC, however, SIPC does not examine broker/dealers and
has no regulatory powers.
Since 1975, the SEC has enforced a net capital rule applicable to all registered broker/dealers.
The rule requires broker/dealers to maintain an excess of capital above mere solvency, to ensure
that a failing firm stops trading while it still has assets to meet customer claims. Net capital levels
are calculated in a manner similar to the risk-based capital requirements under the Basel Accords,
but the SEC has its own set of risk weightings, which it calls haircuts. The riskier the asset, the
greater the haircut.
While the net capital rule appears to be very close in its effects to the banking agencies’ risk-
based capital requirements, there are significant differences. The SEC has no authority to
intervene in a broker/dealer’s business if it takes excessive risks that might cause net capital to
drop below the required level. Rather, the net capital rule is often described as a liquidation
rule—not meant to prevent failures but to minimize the impact on customers. Moreover, the SEC
has no authority comparable to the banking regulators’ prompt corrective action powers: it cannot
preemptively seize a troubled broker/dealer or compel it to merge with a sound firm.
The differences between bank and securities regulation with respect to safety and soundness came
into sharp focus with the collapse of Bear Stearns, one of the five largest investment banks, in
March 2008.13 The SEC monitored Bear Stearns’ financial condition until shortly before the
collapse (which was precipitated by the refusal of other market participants to extend short-term
credit), and believed that the firm had sufficient levels of capital and liquidity. When bankruptcy
suddenly loomed, it was the Federal Reserve that stepped in to broker the sale of Bear Stearns to
JP Morgan Chase by agreeing to purchase $30 billion of “toxic” Bear Stearns assets.
13 See CRS Report RL34420, Bear Stearns: Crisis and “Rescue” for a Major Provider of Mortgage-Related Products,
by Gary Shorter.
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The Bear Stearns situation highlighted several apparent anomalies in the U.S. regulatory
structure. The SEC lacked safety and soundness powers over the institutions it supervised, while
the Fed was forced to commit funds to an investment bank over which it had no regulatory
jurisdiction. The anomaly became even more pronounced when the Fed subsequently established
a lending facility to provide short-term credit to other investment banks.14
The Bear Stearns collapse showed the inability of the SEC to respond to a brokerage failure with
systemic risk implications. There is more to the story, however, than the differences between bank
regulation and the SEC’s net capital rule. In 2004, the SEC devised a voluntary supervisory
scheme for the largest investment banks, called the Consolidated Supervised Entities (CSE)
program.15 The CSE firms were all registered broker/dealers, but were also large holding
companies with extensive operations carried on outside the broker/dealer unit. Thus, the SEC had
no capital requirement that applied to the entire investment bank. Under CSE, this was to change:
as a substitute for the net capital rule, the firms agreed to abide by the Basel risk-based standard,
and maintain that level of capital at the holding company level. On a voluntary basis, the firms
agreed to grant the SEC the authority to examine and monitor their compliance, above and
beyond the SEC’s explicit statutory authority.16
Whatever the intent of the CSE program, it did not succeed in preventing excessive risk-taking by
the participants.17 By the end of September 2008, all five CSE investment banks had either failed
(Lehman Brothers), merged to prevent failure (Merrill Lynch and Bear Stearns), or applied for
bank holding company status (Morgan Stanley and Goldman Sachs).18 On September 26, 2008,
SEC Chairman Cox announced the end of the CSE program, declaring that “[t]he last six months
have made it abundantly clear that voluntary regulation does not work. When Congress passed
the Gramm-Leach-Bliley Act, it created a significant regulatory gap by failing to give to the SEC
or any agency the authority to regulate large investment bank holding companies.”19
Commodity Futures Trading Commission
The Commodity Futures Trading Commission (CFTC) was created in 1974 to regulate
commodities futures and options markets, which at the time were poised to expand beyond their
traditional base in agricultural commodities to encompass contracts based on financial variables
such as interest rates and stock indexes. The CFTC’s mission is to prevent excessive speculation,
manipulation of commodity prices, and fraud. Like the SEC, the CFTC oversees industry self-
regulatory organizations (SROs)—the futures exchanges and the National Futures Association—
and requires the registration of a range of industry firms and personnel, including futures
14 See CRS Report RL34427, Financial Turmoil: Federal Reserve Policy Responses, by Marc Labonte
15 SEC, “Holding Company Supervision Program Description: Consolidated Supervised Entities (“CSEs”),”
http://www.sec.gov/divisions/marketreg/hcsupervision.htm.
16 The Market Reform Act of 1990 permits the SEC to collect certain financial information from unregulated affiliates
of broker/dealers, under the Broker-Dealer Risk Assessment Program.
17 Some argue that CSE allowed the investment banks to hold less capital and increase their leverage. For two views on
this issue, see Stephen Labaton, “Agency’s ‘04 Rule Let Banks Pile Up New Debt, and Risk,” New York Times,
October 3, 2008, p. A1, and: Testimony of SEC Chairman Christopher Cox, House Oversight and Government Reform
Committee, October 23, 2008. (Response to question from Rep. Christopher Shays.)
18 By becoming bank holding companies, Morgan Stanley and Goldman Sachs placed themselves under Federal
Reserve regulation, presumably to signal to the markets that their financial condition was being monitored.
19 SEC, “Chairman Cox Announces End of Consolidated Supervised Entities Program,” press release 2008-230.
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commission merchants (brokers), floor traders, commodity pool operators, and commodity
trading advisers.
Like the SEC, the CFTC does not directly regulate the safety and soundness of individual firms.
Nevertheless, its oversight can have important consequences for the ability of market participants
to manage financial risk. Futures, options, and derivatives can have a systemic impact.
Some argue that the CFTC’s ability to respond to systemic crises is limited because a large part of
the derivatives market is exempt from its jurisdiction. Derivatives contracts may be traded in an
unregulated over-the-counter (OTC) market, so long as no small investors are allowed to trade.
OTC derivatives are some of the largest financial markets in the world, and many OTC market
participants also trade on the CFTC-regulated futures exchanges, but the CFTC does not receive
regular reports about price, volume, and size of positions in the OTC markets.
Federal Housing Finance Agency
The Federal Housing Finance Agency (FHFA) was created in 2008 by the Housing and Economic
Recovery Act of 2008 (P.L. 110-289) to consolidate and strengthen regulation of a group of
housing finance-related government-sponsored enterprises (GSEs): Fannie Mae, Freddie Mac,
and the Federal Home Loan Banks.20 The FHFA succeeded the Office of Federal Housing
Enterprise Oversight (OFHEO) and the Federal Housing Finance Board (FHFB).
The impetus to create the FHFA came from concerns about risk—including systemic risk—
arising from the rapid growth of the GSEs, particularly Fannie and Freddie. These two GSEs
were profit-seeking, shareholder-owned corporations that took advantage of their government-
sponsored status to accumulate undiversified investment portfolios of over $1.5 trillion,
consisting almost exclusively of home mortgages (and securities and derivatives based on those
mortgages).
The FHFA was given enhanced safety and soundness powers resembling those of the federal bank
regulators. These powers included the ability to set capital standards, to order the enterprises to
cease any activity or divest any asset that posed a threat to financial soundness, and to replace
management and assume control of the firms if they became seriously undercapitalized.
The FHFA’s first action was to place both Fannie and Freddie in conservatorship.21 Fannie and
Freddie continue to operate, under an agreement with the U.S. Treasury. The Treasury will
provide capital to the two firms, by means of preferred stock purchases, to ensure that each
remains solvent. In return, the government assumed a 79.9% equity ownership position in the
firms.
20 For more on GSEs and their regulation, see CRS Reports CRS Report RS21724, GSE Regulatory Reform:
Frequently Asked Questions, by N. Eric Weiss, and CRS Report RS21663, Government-Sponsored Enterprises (GSEs):
An Institutional Overview, by Kevin R. Kosar.
21 See CRS Report RS22950, Fannie Mae and Freddie Mac in Conservatorship, by Mark Jickling.
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Regulatory Umbrella Groups
The need for coordination and data sharing among regulators has led to the formation of
innumerable interagency task forces to study particular market episodes and make
recommendations to Congress. Two interagency organizations have attained permanent status.
Federal Financial Institution Examinations Council
The Federal Financial Institutions Examination Council (FFIEC) was created by legislation22 in
1979 as a formal interagency body to coordinate federal regulation of lending institutions.
Through the FFIEC, the federal banking regulators issue a single set of reporting forms for
covered institutions. The FFIEC also attempts to harmonize auditing principles and supervisory
decisions. The FFIEC is made up of the Federal Reserve, OCC, FDIC, OTS, and NCUA, each of
which employs examiners to enforce safety and soundness regulations for lending institutions.
• Federal financial institution examiners evaluate the risks of covered institutions.
The specific safety and soundness concerns common to the FFIEC agencies can
be found in the handbooks employed by examiners to monitor lenders. Each
subject area of the handbook can be updated separately. Examples of safety and
soundness subject areas include important indicators of risk, such as capital
adequacy, asset quality, liquidity, and sensitivity to market risk.
President’s Working Group on Financial Markets
The President’s Working Group on Financial Markets (PWG) was created by President Reagan
through executive order in 1988.23 The PWG includes the Secretary of the Treasury and the
Chairmen of the Federal Reserve, the SEC, and the CFTC. It is not a formal agency subject to
congressional oversight, although each member is subject to Senate confirmation at the time of
appointment.
The impetus for the creation of the PWG was the stock market crash of October 1987, and
specifically the role that the stock index futures markets (under CFTC jurisdiction) had played in
creating panic in the stock market (regulated by SEC). Studies conducted by the SEC, the CFTC,
a blue-ribbon panel appointed by the President (the Presidential Task Force on Market
Mechanisms, or Brady Commission), and the stock and futures exchanges reached strikingly
different conclusions; the task of the PWG was to study the studies and issue a further report.
The PWG was not dissolved, but continued to provide interagency coordination and information
sharing, and to study entities and products that raised intermarket regulatory issues, such as hedge
funds and OTC derivatives. In March 2008, at the direction of President Bush, the PWG issued a
policy statement on the ongoing financial crisis.24
22 P.L. 95-630, 92 STAT. 3641.
23 Executive Order 12631, March 18, 1988, 53 FR 9421.
24 President’s Working Group on Financial Markets, “Policy Statement on Financial Market Developments,” March
2008, http://www.ustreas.gov/press/releases/reports/pwgpolicystatemktturmoil_03122008.pdf.
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Unregulated Markets and Institutions
Although federal financial statutes and regulations fill many volumes, not all participants in the
financial system are regulated. In some cases, unregulated (or self-regulated) markets appear to
work very well, but disruptions or major frauds in these markets are likely to bring calls for
increased government supervision. The dynamic nature of financial markets is a perennial
challenge to regulatory structure design, because a market that appears insignificant at the time a
law is written may grow into a potential threat to systemic stability in a few years. The following
are some of the major unregulated markets and institutions.
Foreign Exchange Markets
Buying and selling currencies is essential to foreign trade, and the exchange rate determined by
traders has major implications for a country’s macroeconomic policy. The market is one of the
largest in the world, with daily turnover in excess of $3 trillion.25 Nevertheless, no U.S. agency
has regulatory authority over the foreign exchange market.
Trading in currencies takes place between large global banks, central banks, hedge funds and
other currency speculators, commercial firms involved in imports and exports, fund managers,
and retail brokers. There is no centralized marketplace, but rather a number of proprietary
electronic platforms that have largely supplanted the traditional telephone broker market.
Despite the fact that extreme volatility in exchange rates for a number of European and Asian
currencies in the 1990s was often blamed on currency speculators, neither U.S. nor foreign
regulators have moved towards regulating the market.
U.S. Treasury Securities
The secondary, or resale, market for Treasury securities is largely unregulated. Like the foreign
exchange market, there is no central exchange, but there are a number of proprietary, computer-
based transaction systems. Treasury securities were exempted from SEC regulation by the
original securities laws of the 1930s. In 1993, following a successful corner of a Treasury bond
auction by Salomon Brothers, Congress passed the Government Securities Act Amendments (P.L.
103-202), which required brokers and dealers that were not already registered with the SEC to
register as government securities dealers. (Existing broker/dealer registrants were simply required
to notify the SEC that they were in the government securities business.) Nevertheless, the
government securities market remains much more lightly regulated than the corporate securities
markets.
The primary market in Treasury securities, where new debt instruments are sold to fund
government operations, is also relatively unregulated. A principal channel for the distribution of
new Treasuries is a group of firms called primary dealers, who purchase securities at auction for
their own accounts and for their customers. The primary dealers are 19 commercial and
investment banks, both foreign and domestic. The primary dealer list is maintained by the Federal
25 Bank for International Settlements, Triennial Central Bank Survey: Foreign exchange and derivatives market
activity, December 2007, p. 1, http://www.bis.org/publ/rpfxf07t.pdf.
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Reserve Bank of New York, which conducts auctions for the Treasury, but its relationship to the
dealers is commercial, rather than regulatory.26 The New York Fed does, however, collect certain
data about primary dealers’ transactions in government securities.
In March 2008, as part of its multifaceted attempt to supply liquidity to the financial system, the
Federal Reserve established a Primary Dealer Credit Facility, to make short-term loans against a
variety of collateral (including asset-backed and mortgage-backed securities) to the primary
dealers.27 This step attracted attention because the primary dealer group included investment
banking firms over which the Fed had no regulatory authority.
OTC Derivatives
As noted above, the Commodity Exchange Act contains exemptions from CFTC regulation for
derivative contracts and markets where all traders are “eligible contract participants,” that is, not
small businesses or retail investors. About two-thirds of OTC derivatives are contracts linked to
interest rates; foreign exchange and credit derivatives each account for about 9%; and contracts
linked to physical commodity and stock prices account for about 2% each.28
Whether the unregulated status of OTC derivatives constitutes a troublesome regulatory gap has
been debated in Congress and among the regulators. One view has been that there is no
government interest in regulating these markets, since all participants are sophisticated and able
to manage the risks. Another is that derivatives contracts make up an invisible web of financial
obligations and exposures, and that the failure of a large derivatives dealer could trigger
cascading losses throughout the global system.
A case that is likely to shape debate is that of AIG, whose insurance operations are regulated by
New York state, but whose large derivatives trading business—the firm was a leader in the credit
default swap market29—was not regulated (although, technically, the firm was a thrift holding
company under OTS supervision). Massive losses in credit default swaps forced the Fed and
Treasury to craft an ad hoc rescue of AIG, which involves over $150 billion in loans and
guarantees.30
Private Securities Markets
The securities laws mandate registration of and extensive disclosures by public securities issuers,
but also provide for private sales of securities, which are not subject to disclosure requirements.
Private placements of securities may only be offered to limited numbers of “accredited investors”
who meet certain asset tests. (Most purchasers are life insurers and other institutional investors.)
There are also restrictions on the resale of private securities.
26 http://www.newyorkfed.org/aboutthefed/fedpoint/fed02.html.
27 Federal Reserve Bank of New York, “Federal Reserve Announces Establishment of Primary Dealer Credit Facility,”
Press Release, March 16, 2008. http://www.newyorkfed.org/newsevents/news/markets/2008/rp080316.html.
28 Bank for International Settlements, Quarterly Review, December 2008, p. A103. http://www.bis.org/publ/qtrpdf/
r_qt0812.htm.
29 See CRS Report RS22932, Credit Default Swaps: Frequently Asked Questions, by Edward V. Murphy.
30 CRS Report RL34427, Financial Turmoil: Federal Reserve Policy Responses, by Marc Labonte.
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The size of the private placement market is subject to considerable variation from year to year,
but at times the value of securities sold privately exceeds what is sold into the public market. In
recent decades, venture capitalists and private equity firms have come to play important roles in
corporate finance. The former typically purchase interests in private firms, which may be sold
later to the public, while the latter often purchase all the stock of publicly traded companies and
take them private.
Nonbank Lenders
During the housing boom of the early 2000s, substantial volumes of mortgages were written not
by chartered depository institutions, but by nonbank lenders with access to credit from Wall Street
firms involved in the securitization of mortgages. These lenders were not subject to safety and
soundness regulation, although they were required to comply with the Federal Reserve’s Truth in
Lending Act consumer protection regulations. Many view these lenders as having been
instrumental in the relaxation of credit standards, leading to what many now regard as the
unsustainable housing price bubble that triggered the current crisis.31
Hundreds of these nonbank mortgage lenders failed in 2007 and 2008, as delinquency rates on
their subprime and other non-traditional mortgages soared. Potential reforms of securitization and
the non-bank lending channel are now under consideration.32
Hedge Funds
Hedge funds are pools of managed money that structure themselves to fit into exemptions in the
federal securities laws—in effect, they are unregulated mutual funds. By limiting the number of
investors, and restricting access to wealthy investors who meet specified asset tests, hedge funds
avoid regulation by the SEC.33 Since there are no reporting requirements, the size of the hedge
fund universe can only be estimated, but before losses in 2008, it was commonly stated that hedge
funds had about $2 trillion of investor funds under management.
Hedge funds have shown their potential for causing systemic disturbances. The case of Long
Term Capital Management (LTCM) is one example of the Federal Reserve arranging for
reorganization of an institution believed to pose systemic risk if it failed. Another hedge fund
debacle—the failure of the Amaranth fund—is said to have caused significant fluctuations in the
price of natural gas.34 It is noteworthy, however, that hedge fund failures do not appear to have
played a major role in the development of the current financial crisis. Some have argued that they
may actually have played a stabilizing role, by absorbing losses that would otherwise have
accrued to regulated financial institutions. But this judgment is regarded by others as premature;
the crisis continues to unfold.
31 Weakening underwriting standards are just one of many explanations for the housing bubble, including unsustainable
capital flows that may have been due to a global savings glut or monetary policies that may have been too expansionary
for too long.
32 See CRS Report RS22722, Securitization and Federal Regulation of Mortgages for Safety and Soundness, by
Edward V. Murphy.
33 See CRS Report 94-511, Hedge Funds: Should They Be Regulated?, by Mark Jickling.
34 United States Senate, Permanent Subcommittee on Investigations of the Committee on Homeland Security and
Governmental Affairs, Staff Report: Excessive Speculation in the Natural Gas Market, June 25, 2007.
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Comprehensive Reform Legislation in the 111th Congress
Although there have been many bills introduced in the 111th Congress that could affect financial
regulation, two comprehensive measures have been addressed by committees of jurisdiction. The
House has aggregated a number of financial reform proposals into H.R. 4173, the “Wall Street
Reform and Consumer Protection Act of 2009.” In the Senate, Chairman Dodd of the Senate
Banking, Housing, and Urban Affairs Committee issued a single comprehensive committee print
on November 16, 2009. Members of the committee are reportedly pairing up to revise Senator
Dodd’s discussion draft in a bipartisan fashion. The major topics of these bills follow the general
outline of Treasury’s proposal that was issued in a series of titles released during the summer of
2009.
Both the House and the Senate bills would reorganize the authorities of some financial regulators.
For example, both bills would remove consumer protection authority from existing financial
regulators and place it all in a single new agency dedicated to consumer financial protection. Both
bills would remove exemptions for financial derivatives and extend CFTC and SEC authority
over more derivatives transactions. Both bills would create a systemic risk council with authority
to identify systemically risky firms, gather market information, and monitor concentrations of risk
in the financial system. Both bills provide authorities with enhanced resolution authority; a failing
systemically important firm would not go through traditional bankruptcy if the systemic risk
authorities believe it would cause financial instability. Both bills would reduce the number of
banking regulators with examination authority. Both bills provide for more information to be
made available to investors and consumers in the marketplace.
There are some significant differences between the two approaches. While the Dodd Committee
Print creates a single bank regulatory authority, H.R. 4173 only merges two of the bank regulators
(the OCC and OTS). H.R. 4173 would allow the systemic risk regulator to preemptively require it
to dispose of assets, or even break it up, if there were concerns about financial stability. The Dodd
Committee Print allows for enhanced resolution of failing firms but not for pre-emptive
intervention for solvent firms.
The House passed H.R. 4173, the Wall Street Reform and Consumer Protection Act of 2009 on
December 11, 2009. The bill included provisions to create a council to address systemic risk,
grant regulators enhanced authority to resolve failing systemically important firms, require more
derivatives to be cleared through regulated organizations, create an agency focused solely on
consumer financial protection, and register some activities of hedge funds. Also, H.R. 4173 was
amended to include a revised version of H.R. 1728, the Mortgage Reform and Anti-Predatory
Lending Act, which had previously passed the House on May 7, 2009. H.R. 1728 establishes
regulatory standards that will apply to all mortgage loans.
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Appendix A. Forms of Banking Organizations
The structure of banks can be complex. Currently, the regulator of a particular activity of a bank
or its subsidiary in part depends on the activity of the subsidiary or its charter, as described above.
The following flow charts provide simplified representations of various bank structures. In some
cases, the umbrella bank and its subsidiaries may have different regulators.
Figure A-1. National Bank
Figure A-2. National Bank and Subsidiaries
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Figure A-3. Bank Holding Company
Figure A-4. Financial Holding Company
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Appendix B. Bank Ratings: UFIRS and CAMELS
Federal bank regulators conduct confidential assessments of covered banks. The Federal
Financial Institutions Examination Council (FFIEC) helps coordinate the ratings system used by
bank examiners so that there is some consistency to the examinations, although the ratings do
take into account differences in bank size, sophistication, complexity of activities, and risk
profile. The FFIEC adopted the Uniform Financial Institutions Rating System (UFIRS) in 1979.
The system was revised in 1996 and is often referred to as the CAMELS rating system. CAMELS
stands for Capital adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity to
market risk. A description of the CAMELS system is found in the Comptrollers Handbook: Bank
Supervision Process, provided by the OCC.35 Market factors can affect more than one category in
the CAMELS ratings.
Capital Adequacy
This component assesses the level of capital held by the institution in relation to the risks that it
takes. Capital adequacy can be affected by a number of factors, including changes in credit risk,
market risk, and the institution’s financial condition. Increases in problem assets would require
increased capital. Capital adequacy is also supposed to reflect risks even if they are technically
off of the bank’s balance sheet.
Asset Quality
Asset quality refers to existing and potential credit risk associated with a the bank’s portfolio.
Like capital adequacy, this component is supposed to reflect risk even if it is not technically on
the bank’s balance sheet. Asset quality can include changes in loan default rates, investment
performance, exposure to counterparty risk, and all other risks that may affect the value or
marketability of an institution’s assets.
Management Capability
The governance of the bank, including management and board of directors, is assessed in relation
to the nature and scope of the bank’s activities. This rating is affected by the level and quality of
management oversight. It also includes legal compliance, responsiveness to auditor
recommendations, and similar issues.
Earnings Quantity and Quality
The rating of a bank’s earnings takes into account current earnings and the sustainability of future
earnings. Earnings that rely on favorable tax effects and nonrecurring events receive lower
ratings. Similarly, inadequate controls for expenses can reduce the rating for earnings. Difficulties
in forecasting and managing risks can also reduce the earnings rating.
35 The Comptrollers handbooks are occasionally updated. The most recent handbook for the Bank Supervision Process
is dated September 2007 and can be found at http://www.occ.gov/handbook/banksup.pdf.
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Liquidity
Liquidity includes the ability of a bank to meet its expected funding needs. For a given institution
size and complexity, this factor assesses the ability of the firm to fulfill its financial obligations in
a timely manner. Liquidity refers to the ability to meet short-term funding needs without incurring
excessive losses, which might occur if assets had to be sold at a steep discount in a time-pressure
situation (or “fire sale”). Liquidity also includes assessments of specific financial categories, such
as the trend and stability of deposits, and the expected ability to securitize and sell pools of assets.
Sensitivity to Market Risk
Market risk includes potential changes in the prices of financial assets, such as movements in
interest rates, foreign exchange rates, commodity prices, and stock prices. The nature and scope
of a bank’s activities can affect the markets that it is exposed to; therefore, market risk is closely
related to the other CAMELS factors. This rating takes into account management’s ability to
identify and manage the risks that can arise from the bank’s trading activities in financial markets.
It also takes into account interest rate risk from nontrading positions, such as any duration
mismatch in loans held to maturity.
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Appendix C. Acronyms
AICPA
American Institute of Certified Public Accountants
CAMELS
Capital Adequacy, Asset Quality, Management, Liquidity, Sensitivity to Market
Risk
CFTC
Commodity Futures Trading Commission
CSE
Consolidated Supervised Entities
EESA
Emergency Economic Stabilization Act
FASB
Financial Accounting Standards Board
FDIC
Federal Deposit Insurance Corporation
FFIEC
Federal Financial Institution Examination Council
FHFA
Federal Housing Finance Agency
FHFB
Federal Housing Finance Board
FRB
Federal Reserve Board
FSLIC
Federal Savings and Loan Insurance Corporation
GAAP
General y Accepted Accounting Principles
GSE
Government-Sponsored Enterprise
NCUA
National Credit Union Administration
OCC
Office of the Comptrol er of the Currency
OFHEO
Office of Federal Housing Enterprise Oversight
OTS
Office of Thrift Supervision
PWG
President’s Working Group on Capital Markets
SEC
Securities and Exchange Commission
SIPC
Securities Investor Protection Corporation
SRO
Self Regulatory Organization
UFIRS
Uniform Financial Institutions Rating System
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Appendix D. Glossary of Terms
This glossary has been compiled from several earlier CRS reports, from the CFTC and SIFMA
websites, and from other sources.
Affiliate—A corporate relationship of control. Two companies are affiliated when one owns all or
a large part of another, or when both are controlled by a third (holding) company (see subsidiary).
All subsidiaries are affiliates, but affiliates that are less than 50% controlled are usually not
treated as subsidiaries.
Agency relationship—A business relationship of two parties in which one represents the other in
transactions with third parties. The agent negotiates on behalf of the party actually at risk, who is
known as the “principal.” A commission goes to the agent who does not take on the risk of the
transaction; the profit or loss goes to the principal.
Asset-backed security—A bond that represents a share in a pool of debt obligations or other
assets. The holder is entitled to some part of the repayment flows from the underlying debt. (See
“securitization.”)
Bank holding company—A business incorporated under state law, which controls through equity
ownership (“holds”) one or more banks and, often, other affiliates in financial services as allowed
by its regulator, the Federal Reserve. On the federal level, these businesses are regulated through
the Bank Holding Company Act.
Bank Holding Company Act—The federal statute under which the Federal Reserve regulates
bank holding companies and financial holding companies (FHC). Besides the permissible
financial activities enumerated in the Gramm-Leach-Bliley Act (P.L. 106-102), the law provides a
mechanism between the Federal Reserve and the Department of the Treasury to decide what is an
appropriate new financial activity for FHCs.
Blue sky laws—State statutes that govern the offering and selling of securities.
Broker/dealer—An individual or firm that buys and sells securities for itself as well as for
customers. Broker/dealers are registered with the Securities and Exchange Commission.
Bubble—Self-reinforcing process in which the price of an asset exceeds its fundamental value
for a sustained period, often followed by a rapid price decline. Speculative bubbles are usually
associated with a “bandwagon” effect in which speculators rush to buy the commodity (in the
case of futures, “to take positions”) before the price trend ends, and an even greater rush to sell
the commodity (unwind positions) when prices reverse.
Capital requirements—Capital is the owners’ stake in an enterprise. It is a critical line of
defense when losses occur, both in banking and nonbanking enterprises. Capital requirements
help assure that losses that might occur will accrue to the institution incurring them. In the case of
banking institutions experiencing problems, capital also serves as a buffer against losses to the
federal deposit insurance funds.
Charter conversion - Banking institutions may, with the approval of their regulators, switch their
corporate form between: commercial bank or savings institution, National or State charter, and to
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stockholder ownership from depositor ownership. Various regulatory conditions may encourage
switching.
Clearing Organization—An entity through which futures and other derivative transactions are
cleared and settled. A clearing organization may be a division or affiliate of a particular exchange,
or a freestanding entity. Also called a clearing house, multilateral clearing organization, or
clearing association.
Collateralized debt obligation (CDO)—A bond created by the securitization of a pool of asset-
backed securities.
Collateralized mortgage obligation (CMO)—A multiclass bond backed by a pool of mortgage
pass-through securities or mortgage loans.
Commercial bank—A deposit-taking institution that can make commercial loans, accept
checking accounts, and whose deposits are insured by the Federal Deposit Insurance Corporation.
National banks are chartered by the Office of the Comptroller of the Currency; state banks, by the
individual states.
Commodity Futures Modernization Act of 2000 (CFMA, P.L. 106-554, 114 Stat. 2763)—
overhauled the Commodity Exchange Act to create a flexible structure for the regulation of
futures and options trading, and established a broad statutory exemption from regulation for OTC
derivatives.
Community financial institution—As provided for in the Gramm-Leach-Bliley Act, a member
of the Federal Home Loan Bank System whose deposits are insured under the Federal Deposit
Insurance Act and which has assets of less than $500 million (calculated according to provisions
in the law, and in succeeding years to be adjusted for inflation). Such institutions may become
members without meeting requirements with regard to the percentage of total assets that must be
in residential mortgage loans and may borrow from the Federal Home Loan Banks for small
business and agriculture.
Conservatorship—When an insolvent financial institution is reorganized by a regulator with the
intent to restoring it to an ongoing business.
Counterparty—The opposite party in a bilateral agreement, contract, or transaction, such as a
swap.
Credit Default Swap (CDS)—A tradeable contract in which one party agrees to pay another if a
third party experiences a credit event, such as default on a debt obligation, bankruptcy, or credit
rating downgrade.
Credit Risk—The risk that a borrower will fail to repay a loan in full, or that a derivatives
counterparty will default.
Credit union—A nonprofit financial cooperative of individuals with one or more common bonds
(such as employment, labor union membership, or residence in the same neighborhood). May be
state or nationally chartered. Credit unions accept deposits of members’ savings and transaction
balances in the form of share accounts, pay dividends (interest) on them out of earnings, and
primarily provide consumer credit to members. The federal regulator for credit unions is the
National Credit Union Administration.
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Dealer—An individual or financial firm engaged in the purchase and sale of securities and
commodities such as metals, foreign exchange, etc., for its own account and at its own risk as
principal (see broker). Commercial banks are typically limited to acting as dealers in specified
high-quality debt obligations, such as those of the federal government.
Depository institution—Customarily refers to commercial banks, savings institutions, and credit
unions, since traditionally the greater part of their funding has been in the form of deposits.
Deposits are a customer’s funds placed with an institution according to agreed on terms and
conditions and represent a credit to the depositor.
Derivatives—Financial contracts whose value is linked to the price of an underlying commodity
or financial variable (such as an interest rate, currency price, or stock index). Ownership of a
derivative does not require the holder to actually buy or sell the underlying interest. Derivatives
are used by hedgers, who seek to shift risk to others, and speculators, who can profit if they can
successfully forecast price trends. Examples include futures contracts, options, and swaps.
Discount window—Figurative term for the Federal Reserve facility for extending credit directly
to eligible depository institutions. It may be used to relieve temporary cash shortages at banks and
other depository institutions. Borrowers are expected to have tried to borrow elsewhere first and
must provide collateral as security for loans. The term derives from the practice whereby bankers
would come to a Reserve Bank teller window to obtain credit in the early days of the Federal
Reserve System.
Dual banking system—The phrase refers to the fact that banks may be either federally or state-
chartered. In the case of state-chartered banks, the state is the primary regulator; for national
banks, the Office of the Comptroller of the Currency is the primary regulator.
Electronic fund transfer (EFT) systems—A variety of systems and technologies for transferring
funds electronically rather than by paper check.
Exchange—A central marketplace with established rules and regulations where buyers and
sellers meet to trade futures and options contracts or securities.
Federal Home Loan Banks—Twelve regional member-owned federally sponsored organizations
that extend credit to their member banking institutions, largely to finance mortgages made to
homeowners. The 12 FHLBs make up a single government-sponsored enterprise.
Federal safety net—A broad term referring to protection of banking institutions through deposit
insurance, discount window credit, other lender of last resort support, and certain forms of
regulations to reduce risk. Commercial and industrial companies generally lack any of these
cushions against loss.
Financial businesses—In discussions about financial services modernization, usually refers to
commercial banks and savings institutions, securities firms, and insurance companies and agents,
as contrasted with commercial and industrial firms.
Financial holding company—A holding company form authorized by the Gramm-Leach-Bliley
Act that goes beyond the limits a of bank holding company. It can control one or more banks,
securities firms, and insurance companies as permitted by law and/or regulation.
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Financial institution—An enterprise that uses its funds chiefly to purchase financial assets such
as loans and debt securities, as opposed to tangible property. Financial institutions are
differentiated by the manner in which they invest their funds: in loans, bonds, stocks, or some
combination; as well as by their sources of funds. Depository financial institutions are
differentiated in that they may accept deposits which are federally insured against loss to the
depositor. Nondepository financial institutions such as life and property/casualty insurance
companies, pension funds, and mutual funds obtain funds through other types of receipts, whose
values may fluctuate with market conditions.
Financial subsidiary—Under the Gramm-Leach-Bliley Act, both national and state-chartered
banks are authorized to form financial subsidiaries to engage in activities that would not
otherwise be permitted within the bank itself, subject to certain limits. Besides the permissible
financial activities enumerated in P.L. 106-102, the law provides a mechanism between the U.S.
Department of the Treasury and the Federal Reserve to decide what is an appropriate new
financial activity for a financial subsidiary.
Firewalls—Barriers to the flow of capital, information, management, and other resources among
business units owned by a common entity. In case of financial distress of one operation (“fire”),
the “walls” are intended to prevent the spread of loss to the other units—especially to banking
units. Example: losses in a securities subsidiary of a holding company could not be covered by
any of the holding company’s bank subsidiaries.
Foreign bank—Banks and their holding companies headquartered in other countries may have a
variety of financial operations in the United States: U.S.-chartered subsidiary banks, agencies,
branches, and representative offices. Their primary federal regulator is the Federal Reserve, under
the International Banking Act of 1978 as amended. States and the Office of the Comptroller of the
Currency may also regulate them.
Functional regulation—Regulatory arrangements based on activity (“function”) rather than
organizational structure. The Gramm-Leach-Bliley Act called for more functional regulation than
in the past.
Glass-Steagall Act—Part of the Banking Act of 1933; divided the commercial and investment
banking industries. The Gramm-Leach-Bliley Act repealed two sections of the act dealing with
the relationship between banks and securities firms.
Government-sponsored enterprise (GSE)—GSEs are private companies with government
charters. Government sponsorship typically gives them a funding advantage over purely private
competitors, while their charters restrict the kinds of businesses they may conduct.
Gramm-Leach-Bliley Act of 1999—P.L. 106-102, also known as the Financial Services
Modernization Act, authorized increased affiliations between banks, securities firms, and insurers.
Permitted the establishment of financial holding companies, under the regulation of the Federal
Reserve. Also addressed privacy protection for consumers’ financial data.
Haircut—In computing the value of assets for purposes of capital, segregation, or margin
requirements, a percentage reduction from the stated value (e.g., book value or market value) to
account for possible declines in value that may occur before assets can be liquidated.
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Hedge funds—Hedge funds are essentially unregulated mutual funds. They are pools of invested
money that buy and sell stocks and bonds and many other assets, including precious metals,
commodities, foreign currencies, and derivatives (contracts whose prices are derived from those
of other financial instruments). Hedge funds are limited to qualified investors with high net
worth.
Hedging—Investing with the intention of reducing the impact of adverse movements in interest
rates, commodities, or securities prices. Typically, the hedging instrument gains value as the
hedged item loses value, and vice versa.
Insolvent—A firm whose liabilities exceed its assets.
Institutional regulation—Regulation that is institution-specific as contrasted with activity-
specific (see functional regulation).
Investment bank—A financial intermediary, active in the securities business. Investment
banking functions include underwriting (marketing newly registered securities to individual or
institutional investors), counseling regarding merger and acquisition proposals, brokerage
services, advice on corporate financing, and proprietary trading.
Investment bank holding company—A holding company for securities firms authorized under
the Gramm-Leach-Bliley Act. Such holding companies are subject to regulation by the Securities
and Exchange Commission.
Issuer—A person or entity (including a company or bank) that offers securities for sale. The
issuing of securities, where the proceeds accrue to the issuer, is distinct from the secondary, or
resale, market, where securities are traded among investors.
Lender of last resort—Governmental lender that acts as the ultimate source of credit in the
financial system. In the United States, the Federal Reserve has this role.
Leverage—The ability to control large dollar amounts of a commodity or security with a
comparatively small amount of capital. Leverage can be obtained through borrowing or the use of
derivatives.
Limited-purpose bank—Although generally commercial firms may not conduct a banking
business, some exceptions exist. Examples: Nonbank banks are banks that either accept deposits
or make commercial loans but cannot do both. Such banks grew up through a loophole in law
which was closed by the Competitive Equality Banking Act of 1987 (CEBA). Credit card banks
conduct credit card operations. Industrial loan companies in a few states may offer restricted
banking services.
Liquidity—The ability to trade an asset quickly without significantly affecting its price, or the
condition of a market with many buyers and sellers present. Also, the ability of a person or firm to
access credit markets.
Liquidity risk—The possibility that the market for normally-liquid assets will suddenly dry up,
leaving firms unable to convert assets into cash. Also, the risk that other firms will refuse to
extend credit on any terms to a firm that is perceived as distressed.
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Market risk—The risk that the price of a tradeable security or asset will decline, resulting in a
loss to the holder.
Merchant banker—A European style investment banker concentrating on corporate deals, in
which it may invest its own funds.
Money market mutual fund (MMF)—A form of mutual fund that pools funds of individuals
and other investors for investment in high-grade, short-term debt and bank deposits paying
market rates of return. Examples of these money market instruments include U.S. Treasury bills,
certificates of deposit, and commercial paper. In addition to the investment features, most MMFs
offer check-writing redemption features.
Moral hazard—The tendency of people to take more risks once another party has agreed to
provide protection. Regulatory interventions to bail out failing firms are often said to create moral
hazard, on the assumption that others will expect to be saved from their mistakes, too.
Mortgage-backed security (MBS)—A bond backed by a pool of mortgage loans. The
bondholders receive a share of the interest and principal payments on the underlying mortgages.
The cash flows may be divided among different classes of bonds, called tranches.
Mutual fund—An investing company that pools the funds of individuals and other investors, and
uses them to purchase large amounts of debt or equity obligations of businesses and sometimes
debt obligations of governments. The owners of the mutual fund hold proportional shares in the
entire pool of securities in which a fund invests. Owners pay taxes on their distributions from a
fund; the mutual fund itself is not normally subject to federal or state income taxation.
Naked option—The sale of a call or put option without holding an equal and opposite position
in the underlying instrument.
Operational risk—The possibility that a financial institution will suffer losses from a failure to
process transactions properly, from accounting mistakes, from rogue traders or other forms of
insider fraud, or from other causes arising inside the institution.
Over-the-counter (OTC)—Trading that does not occur on a centralized exchange or trading
facility. OTC transactions can occur electronically or over the telephone.
Ponzi Scheme—Named after Charles Ponzi, a man with a remarkable criminal career in the early
20th century, the term has been used to describe pyramid arrangements whereby an enterprise
makes payments to investors from the proceeds of a later investment rather than from profits of
the underlying business venture, as the investors expected, and gives investors the impression that
a legitimate profit-making business or investment opportunity exists, where in fact it is a mere
fiction.
Receivership—When an insolvent financial institution is taken over with the intent to liquidate
its assets.
Resolution Trust Corporation (RTC) - The agency set up to resolve savings and loans declared
failed beginning in 1989. Between 1989 and mid-1995, the Resolution Trust Corporation closed
or otherwise resolved 747 thrifts with total assets of $394 billion.
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Savings association—A savings and loan association, mutual savings bank, or federal savings
bank, whose primary function has traditionally been to encourage personal saving (thrift) and
home buying through mortgage lending. In recent years, such institutions’ charters have been
expanded to allow them to provide commercial loans and a broader range of consumer financial
services. The federal regulator for most savings associations is the Office of Thrift Supervision.
Also known as savings and loans, thrifts, and mutual savings banks.
Securities Investor Protection Corporation (SIPC)—A private nonprofit membership
corporation set up under federal law to provide financial protection for the customers of failed
brokers and/or dealers. SIPC is a liquidator; it has no supervisory or regulatory responsibilities for
its members, nor is it authorized to bail out or in other ways assist a failing firm.
Securitization—The process of transforming a cash flow, typically from debt repayments, into a
new marketable security. Holders of the securitized instrument receive interest and principal
payments as the underlying loans are repaid. Types of loans that are frequently securitized are
home mortgages, credit card receivables, student loans, small business loans, and car loans.
Self-regulatory organizations (SROs)—National securities or futures exchanges, national
securities or futures associations, clearing agencies and the Municipal Securities Rulemaking
Board are all authorized to make and enforce rules governing market participants. The respective
federal regulatory agency has authority in connection with SROs and may require them to adopt
or modify their rules. Examples of SROs in the securities industry include the Financial Industry
Regulatory Authority (FINRA), and the New York Stock Exchange.
Special-purpose entities (SPEs)—Also referred to as off–balance-sheet arrangements, SPEs are
legal entities created to perform a specific financial function or transaction. They isolate financial
risk from the sponsoring institution and provide less-expensive financing. The assets, liabilities,
and cash flows of an SPE do not appear on the sponsoring institution’s books.
Speculation—a venture or undertaking of an enterprising nature, especially one involving
considerable financial risk on the chance of unusual profit.
State regulation—Under the dual system of bank regulation, states as well as the federal
government may charter, regulate, and supervise depository institutions. States are the primary
regulators in the insurance field. States also have authority over securities companies, mortgage
lending companies, personal finance companies, and other types of companies offering financial
services.
Structured debt—Debt that has been customized for the buyer, often by incorporating complex
derivatives.
Subordinated debt—Debt over which senior debt takes priority. In the event of bankruptcy,
subordinated debtholders receive payment only after senior debt claims are paid in full.
Subsidiary—A company whose controlling shares are owned 50% or more by another (“parent”)
corporation. Like companies with less than 50% ownership, it is an affiliate of the controlling
company. A subsidiary is usually consolidated for regulatory and reporting purposes with its
parent.
Systemic Risk—The term “systemic risk” does not have a single, agreed-upon definition. Some
define systemic risk as the risk an institution faces that it cannot diversify against. In other
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circumstances, systemic risk is defined as the risk that the linkages between institutions may
affect the financial system as a whole, through a dynamic sometimes referred to as contagion.
Thrift holding company—Also known as a savings and loan holding company, a business that
controls one or more savings associations. These holding companies are regulated under the
Home Owners’ Loan Act by the Office of Thrift Supervision.
Too-big-to-fail doctrine—an implicit regulatory policy holding that very large financial
institutions must be rescued by the government, because their failure would destabilize the entire
financial system. (See “moral hazard.”)
Umbrella supervision—The term applied to comprehensive regulation of a holding company
and its parts by one or more holding company regulator(s).
Underwriter—For securities markets, see investment bankers. For insurance, underwriters are
the life, health and property-casualty companies that receive premiums and pay off losses and
other risks as they occur. The underwriters bear the risks of losses and expenses exceeding
receipts.
Unitary thrift holding company (UTHC)—A holding company that owns a single thrift
institution. A distinction between UTHCs and other thrift holding companies has been that a
UTHC could be involved in any lines of business, whereas the others have been restricted to
certain activities primarily financial in nature. The Gramm-Leach-Bliley Act limits the
commercial activities and affiliations of new UTHCs.
Universal bank—An organizational model typical of some foreign countries whereby a bank can
exist as an operating enterprise and own directly a variety of other businesses (See Subsidiary). It
contrasts with the banking model typical in the United States where the parent holding company
owns several different businesses, all structurally separate (See “affiliate.”). In practice, the two
approaches are not exclusive.
Author Contact Information
Mark Jickling
Edward V. Murphy
Specialist in Financial Economics
Specialist in Financial Economics
mjickling@crs.loc.gov, 7-7784
tmurphy@crs.loc.gov, 7-6201
Acknowledgments
The authors gratefully acknowledge helpful comments from our colleagues Walter Eubanks, Marc Labonte,
and Maureen Murphy.
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